Everything Canadians Need to Know About Unexercised Employee Stock Options: Income Tax Liabilities, Dispositions, Buyouts and Cancellations

Introduction – Income Tax for Canadians who hold Employee Stock Options

Many employers opt to compensate their Canadian employees with options to purchase shares in the business at a discounted price. A CCPC employee stock option (ESO) gives the employee the right to purchase shares in the employer’s corporation at a fixed price during a set period. Should the value of the shares later exceed the option price, the employee may exercise the option and thereby purchase those shares at the bargain option price. The employee can then sell the shares and immediately realize a profit.

From an employer’s perspective, employee stock options can be an attractive means of compensating employees. First, employee stock options may provide employees with an incentive to work harder, contribute to the employer’s bottom line, and therefore increase the value of the corporation and its shares. And through the use of vesting periods, the employee stock option provides an incentive for the employee to stay with the corporation. In addition, by offering ESOs as part compensation, the employer incurs minimal risk should the company perform poorly. In this case, the value of the employer’s shares will fall below the option price, and the employees will presumably abstain from exercising their options.

Canadian employees, however, may not fully understand the Canadian income-tax implications of ESOs. While some Canadian employees may appreciate the Canadian income-tax implications of exercising an ESO and selling the underlying shares, very few understand the Canadian tax implications of transferring, selling, cancelling, or redeeming the unexercised ESO rights.

This article examines the income-tax implications for Canadian employees who transfer or sell their unexercised employee stock options and the income-tax implications for Canadian employees whose employers cancel or redeem the employees’ unexercised ESOs. We first review the basic Canadian income-tax rules concerning ESO benefits. Afterwards, we discuss the income-tax consequences for a Canadian employee who disposes of the unexercised rights under an employee stock option. We then discuss the availability of an ESO tax deduction under subsection 110(1) of Canada’s Income Tax Act. The article concludes by offering pro tax tips for Canadian employees and businesses from our expert Canadian tax lawyers.

Canadian Income-Tax Implications of Employee Stock Options

A Canadian employee doesn’t incur any tax liability when the employer grants the stock options. Rather, the Canadian income-tax consequences arise either (1) when the employee exercises the options, thereby acquiring the shares, or (2) when the employee disposes of unexercised options. Although each case gives rise to an employee benefit, which the employee must report as employment income under subsection 7(1) of Canada’s Income Tax Act, the applicable tax rules alter the timing of the income inclusion. And in the case where the employee exercises the ESOs, the legislation also adjusts the tax cost of the shares that the employee acquired under the option.  The following sections first discuss the income-tax consequences of exercising the ESOs and then discuss the tax effect of disposing of unexercised ESOs, whether by transfer, sale, or cancellation.

Income-Tax Implications of Exercising an Employee Stock Option: Taxable Employee Benefit & Tax-Cost Adjustment

An employee who exercises ESOs must account for the resulting benefit by reporting the value of the benefit as taxable employment income. The amount of the employee benefit equals the result of the formula A minus B, where:

• A is the fair market value of the shares at the time the employee exercised the employee stock options; and
• B is the option price plus any amount that the employee paid to purchase the option.

For example, suppose the following: An employee receives employee stock options granting the right to buy 150 shares for $10.  The employee paid nothing to acquire the ESOs. The employee later exercises the options when 150 shares in the company are worth $20.

The amount that the employee must report as a taxable employee benefit is $10 (i.e., $20 value of shares upon exercising options – $10 option price). The employer is typically also required to withhold payroll tax on the benefit and report the benefit on the employee’s T4 slip for the relevant tax year.

The tax year in which the employee must report the benefit as taxable income depends on whether or not the ESO shares were those of a Canadian-controlled private corporation (CCPC). If the ESO shares are those of a Canadian-controlled private corporation, the employee need not report the resulting employee benefit until he or she sells the shares.  If, however, the shares acquired under the ESOs were those of a non-CCPC—i.e., a public corporation or a foreign corporation—the employee must report the resulting employee benefit as taxable income for the year in which the employee exercised the employee stock options and acquired the shares.

Canada’s tax system delays the tax liability for employees who acquire CCPC shares because of the market forces and liquidity issues that those shareholder-employees often face. The market for shares in a Canadian-controlled private corporation is typically restricted and far smaller than that for shares in a public corporation. If employees acquiring CCPC shares were required to pay tax when acquiring shares that they couldn’t readily sell, they’d face a liquidity issue. So, these employees need not report the employee benefit until the year that they sell their shares and thus presumably have the cash to pay the tax. Employees acquiring shares in a public corporation, on the other hand, don’t generally encounter much resistance when attempting to sell their shares. They can access eager buyers on the stock exchange that lists their employer’s company. Those employees must therefore report the taxable employee benefit as income for the year in which they exercised the ESOs and acquired the shares.

In any event, the resulting employee benefit is calculated in the same way, and it forms a part of that employee’s taxable employment income. The only difference is the timing of the income inclusion.

Canada’s Income Tax Act also adjusts the tax attributes of the shares that the employee acquired under the ESO. The employee may realize a capital gain when selling the shares. Yet if the tax cost of those shares were not adjusted to account for the already taxed employee benefit, the employee would suffer double taxation. To prevent that, Canada’s tax rules increase the tax cost (a.k.a. adjusted cost base or ACB) of the acquired shares by the amount of the taxable employee benefit that the employee must report as income.

For example, suppose that an employee exercises employee stock options allowing the employee to purchase 100 shares at an option price of $10. At the time the employee exercised the ESOs, the underlying shares were worth $15.  The employee subsequently sells the shares for $17.

In this case, the amount of the taxable employee benefit from exercising the employee stock option is: $15 – $10 = $5. (In some circumstances, the benefit can be reduced by half under subsection 110(1), which we discuss in more detail below.) As mentioned above, the employee reports the taxable employee benefit as employment income, either for the taxation year in which she exercised the employee stock option (non-CCPC shares) or for the taxation year in which she sells the shares (CCPC shares).

The $5 employee benefit is then added to the tax cost of the 100 shares that the employee acquired upon exercising the ESOs. In other words, the $5 employee benefit is added to the $10 that the employee paid to acquire the ESO shares. The employee’s tax cost for the 100 shares is therefore $15. When the employee sells the shares for $17, it results in a capital gain of $2.00, half of which is the employee’s taxable capital gain.

Income-Tax Implications of Transfers, Dispositions, Buyouts & Cancellations of Unexercised Employee Stock Options

The previous section discussed the tax consequences for an employee who exercises the employee stock options and disposes of the acquired shares. This section focuses on the income-tax consequences that arise when an employee disposes of ESOs that remain unexercised. This situation might come about if, for instance, the employee transfers or sells the ESO rights without exercising them, or if the employer cancels the options, paying out the employee instead.

These situations fall under paragraphs 7(1)(b) and 7(1)(b.1) of Canada’s Income Tax Act. These paragraphs apply when an employee “has transferred or otherwise disposed of rights under” the ESO agreement between the employee and employer. That is, they cover situations where the employee has transferred the options themselves. Specifically, paragraph 7(1)(b) applies when the employee transfers the ESO rights to a person with whom the employee dealt at arm’s length, and paragraph 7(1)(b.1) applies when the employee transfers the ESO rights back to the employer that granted them or transfers the ESO rights to a corporation with whom the employer does not deal at arm’s length (e.g., the employer’s parent company).

In each case, the employee will realize a taxable employee benefit, which equals the result of formula A minus B, where:

• A is the value of the employee’s consideration for disposing of the ESO rights; and
• B is the amount, if any, that the employee paid to acquire the ESO rights.

The resulting amount is deemed to be a taxable employee benefit that the employee received in the taxation year during which the employee transferred or disposed of the ESO rights.

To illustrate: Suppose that, in 2021, an employee received employee stock options granting the right to buy 150 shares for $1,000.  The employee paid nothing to acquire the ESOs. In 2022, the employer’s parent company cancelled the ESOs, which the employee never never exercised, and paid $3,000 to the employee.

The result, under paragraph 7(1)(b.1), is that the employee is deemed to have received a $3,000 taxable employee benefit, which the employee must report as employment income for the 2022 taxation year. (The employer may also be required to withhold payroll tax on the $3,000 and report the benefit on the employee’s T4 slip.) An ACB adjustment is unnecessary here because the employee never exercised the options and therefore acquired no shares.

Tax Deduction for Taxable Employee Benefits: Paragraphs 110(1)(d) and 110(1)(d.1)

The previous sections demonstrated that Canadian employees may need to report taxable employee benefits if they exercise ESOs, sell shares acquired under ESOs, or transfer ESO rights. Although the taxable employee benefit is reportable as employment income, subsection 110(1) of Canada’s Income Tax Act allows a qualifying employee to report only one-half of the ESO benefit. This deduction effectively reduces the ESO-benefit tax rate to the capital-gains tax rate.

Paragraph 110(1)(d) lays out the general criteria for the ESO tax deduction.  Under paragraph 110(1)(d), the employee may deduct half of the ESO benefit when computing taxable income if: (1) the employee stock options entitled the employee to receive common shares; (2) the employee dealt at arm’s length with the employer; and (3) the option price (including any amount paid to acquire the ESO) equaled or exceeded the value of the underlying shares at the time that the option was granted. An employee may also qualify for this deduction if the employee disposes of the rights to an unexercised ESO, but this deduction is unavailable if the option price was less than the share value at the time that the option was granted.

For example: Assume that the option price was $10 for 15 shares, and that, at the time that the option was granted, the 15 shares were worth $25. In this case, the employee cannot qualify for the one-half ESO tax deduction because the share value exceeded the option price at the time that the option was granted.

Employees who exercised ESOs and acquired CCPC shares can also claim a deduction under paragraph 110(1)(d.1). For employees receiving CCPC shares, paragraph 110(1)(d.1) grants the same one-half deduction but with fewer constraints. If, under the employee stock option, the employee receives shares in a CCPC, the employee receives the one-half deduction as long as the employee held the shares for at least 2 years and has not already claimed a deduction under paragraph 110(1)(d).

Pro Tax Tips –Tax Planning & Tax-Audit Defence for Canadians Holding Employee Stock Options

If you plan on selling the shares you acquire from exercising your employee stock option, you can theoretically defer the resulting capital gain by selling these shares the following year. For instance, if you acquired your shares in 2022, you can defer the need to report and thus pay tax on any capital gain by selling the shares at the beginning of 2023.  If you sold the shares in 2022, your tax liability for any resulting capital gain would arise on April 30, 2023. But by selling the shares on, say, January 1, 2023, you delay that tax liability until April 30, 2024.

The risk, of course, is that, if you delay the sale, the shares may lose value in the interim. Moreover, you unfortunately cannot use that loss to offset the income relating to the ESO benefit. As mentioned above, if an employee receives a taxable employee benefit relating to employee stock options, that benefit is reportable as employment income, yet any loss from selling the acquired shares is generally reportable as a capital loss. You cannot deduct capital losses against other sources of income.  As a result, if you sell the ESO shares at a loss, you lose not only monetarily but also taxwise, because you cannot offset your taxable ESO benefit using that capital loss.

So, you generally want to sell the shares soon after exercising your employee stock option and acquiring them. Moreover, the expiry date for some ESOs aligns with the end of the calendar year.

One tax-planning option is for the Canadian employee to exercise the employee stock options as late in the year as possible, which ideally allows the employee to sell the shares shortly after acquiring them yet still after the year end. The employee thereby defers the Canadian tax liability on the resulting capital gain while both exercising the option before it expires and reducing exposure to the risk that the shares may lose value.

Whether you’re an employee who has received an employee stock option or an employer considering potential compensation packages, consult one of our expert Canadian tax lawyers for advice on more sophisticated tax-planning strategies and structures.

Moreover, Canadians who have received, exercised, or transferred employee stock options should gather and retain all supporting documents in case the Canada Revenue Agency’s tax auditors want to review your claim. You should, for instance, retain the option agreement, your employer’s confirmation that the option price equaled the value of the underlying shares, the cancellation agreement (if any), a schedule showing exactly how your employer calculated the benefit reported on your T4 slip, etc. Fortunately, Canadian employees who have received, exercised, or transferred employee stock options can often avoid tax-audit problems through early engagement of an experienced Canadian tax lawyer.  Speak to our Certified Specialist in Taxation Canadian tax lawyer today.

FREQUENTLY ASKED QUESTIONS

Question: What is an employee stock option (ESO)?

Answer: An employee stock option (ESO) grants an employee with the right to purchase shares in the employer’s corporation at a fixed price during a set period. Should the value of the shares later exceed the option price, the employee may exercise the option and thereby purchase those shares at the bargain option price. The employee can then sell the shares and immediately realize a profit.

Question: I exercised an employee stock option that was granted by my Canadian employer. How much will I pay in Canadian tax?

Answer: This information is insufficient to determine your Canadian tax liability stemming from your ESOs. To explain why, we should review the basic Canadian tax rules relating to ESO benefits. An employee who exercises ESOs must account for the resulting benefit by reporting the value of the benefit as taxable employment income. The amount of the employee benefit equals the result of the formula A minus B, where:

• A is the fair market value of the shares at the time the employee exercised the employee stock options; and
• B is the option price plus any amount that the employee paid to purchase the option.

In addition, the tax year in which the employee must report the benefit as taxable income depends on whether or not the ESO shares were those of a Canadian-controlled private corporation. If the ESO shares are those of a Canadian-controlled private corporation, the employee need not report the resulting employee benefit until he or she sells the shares.  If, however, the shares acquired under the ESOs were those of a non-CCPC—i.e., a public corporation or a foreign corporation—the employee must report the resulting employee benefit as taxable income for the year in which the employee exercised the employee stock options and acquired the shares.

Furthermore, subsection 110(1) of Canada’s Income Tax Act allows a qualifying employee to report only one-half of the ESO benefit. This deduction effectively reduces the ESO-benefit tax rate to the capital-gains tax rate. The availability of this deduction depends on (amongst other things) whether the option price equaled or exceeded the share value at the time that the options were issued, and whether the options related to shares in a Canadian-controlled private corporation.

As a result, we cannot determine your Canadian tax liability without knowing (at the very least) the option price, whether you paid anything to acquire the options, the value of the underlying shares at the time that the options were issued and at the time that the options were exercised, whether the options permitted you to acquire shares in a CCPC, and whether you have since disposed of any of the shares that you acquired under the ESO. Of course, we also need to know which tax bracket you fall under. To discuss the extent of your potential tax liability and whether any tax-planning options are available to reduce the Canadian tax relating to your ESOs, consult one of our expert Canadian tax lawyers today.

Question: I received ESOs from my employer a few years ago. This year, my employer’s company was purchased by another company, which will buy out my ESOs. I’ve never exercised any of the ESOs. Does this mean that I need not report a taxable employee benefit relating to my ESOs?

Answer: No. This situation will likely fall under paragraph 7(1)(b.1) of Canada’s Income Tax Act. This paragraph applies when an employee transfers the ESO rights back to the employer that granted them or transfers the ESO rights to a corporation with whom the employer does not deal at arm’s length (e.g., a buyout by the employer’s new parent company). In this case, the employee realizes a taxable employee benefit that equals the result of formula A minus B, where:

• A is the value of the employee’s consideration for disposing of the ESO rights; and
• B is the amount, if any, that the employee paid to acquire the ESO rights.

The resulting amount is deemed to be a taxable employee benefit that the employee received in the taxation year during which the employee transferred or disposed of the ESO rights.

Our knowledgeable Canadian tax lawyers can advise whether this tax rule applies in your circumstances. We can also advise whether any tax-planning opportunities are available.

 Question: I must report taxable benefits relating to employee stock options. Which supporting documents should I retain in case I’m selected for a tax audit by the Canada Revenue Agency?  

Answer: You should retain, at the very least, the option agreement, your employer’s confirmation as to whether the option price equaled the value of the underlying shares, the cancellation agreement (if any), and a schedule showing exactly how your employer calculated the benefit reported on your T4 slip. The relevant supporting documents will also depend on whether you plan on claiming the 50% ESO tax deduction under subsection 110(1) of Canada’s Income Tax Act. For advice on how to audit-proof your claim, speak to our Certified Specialist in Taxation Canadian tax lawyer today.

DISCLAIMER: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.